CJP’s Glossary of Finance: What is commercial paper?

By Nisha | October 7, 2008

Headlines today are saying that the Federal Reserve is purchasing “commercial paper, ” and investors are cheering because these supposedly will help the credit crisis. Don’t know what commercial paper is? Well a gal’s gotta be informed, so read on!

Commercial paper is a short-term purchase of unsecured debt by large banks and corporations, and is secured with a promissory note. It’s often used by corporations and businesses in need of short-term financing for current transactions, and can be a cheaper alternative to bank loans, hence the popularity. It’s very short-term — they are usually an average of 30 days.

What about asset-backed commercial paper? While commercial paper itself is relatively uncomplicated, asset-backed CP is a little more tricky and of course, a lot more risky! Instead of just a regular CP, which is an unsecured promissory note, an ABCP is backed by securities. So, the quality of the ABCP depends on the underlying securities. This gets tricky, however, when the market value of the underlying assets is reduced (because they’re marked-to-market, and you already know what that is!) before the CP matures.

Why is the Fed buying commercial paper? The hope is that buying up some of the (short-term) debt will inject some liquidity in the market and help companies strapped for cash. Small businesses often rely on commercial paper to fund their daily operations, and while they could normally sell to banks or large corporations, many banks are hesitant to lend right now, so the Fed is stepping in to directly help these small businesses.

Topics: Economy, Glossary

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